Tears, Fears for China's Property Gamblers

Battered by global financial turmoil, foreign investors are moving quickly to liquidate stakes in Chinese property developers. The market is sinking, and investors are eager for a way out.

Real estate developers, including some of the nation’s largest, are fighting to stay afloat. And so far, none have declared bankruptcy.

But key developers who snapped up land and, sometimes in a desperate scurry for cash, signed deals with equity funds and investment banks during China’s property market boom are now slipping toward loan defaults and failure.

One sign of the crisis is a dispute between China’s Agile Property Holdings (HKSE: 03383) and the U.S.-based private real estate fund Aetos Capital Asia. Another involves allegations that Neo-China Land Group (Holdings) Ltd. (HKSE: 02528) missed a coupon payment.

Yet these cases may be just the tip of the iceberg. Many developers may be on the brink in the face of looming payments for high interest convertible bonds and other debt.

Among the worse-off are developers who signed so-called valuation adjustment mechanisms (VAM), which in Chinese are called “gambling agreements.” Deals were cut with foreign investment banks and funds raised through private placements in hopes IPOs launched on the Hong Kong Stock Exchange could be used to repay the investors. When IPOs failed, VAMs turned toxic.

As the climate worsens, foreign investment banks are preparing to launch debt restructurings for real estate companies that can’t make debt payments or go public, said a top bank executive. More than 20 developers are facing such crises, the banker disclosed.

A restructuring could be used to settle debts based on the value of property projects. And for some developers who are running out of money, it may be the only option short of collapse.

Agile-Aetos Dispute

Agile announced January 16 that Aetos had unilaterally decided in October to terminate its planned equity purchase of a stake in a Huizhou development called Huizhou Bailulu. The foreign company also sought to reclaim its 1.2 billion yuan deposit, with interest, Agile said.

But the Chinese company -- a major GuangdongProvince developer with annual sales of more than 10 billion yuan – isn’t paying.

One of Guangdong’s five largest real estate kingpins, Agile in recent years switched its investment focus from residential to tourism projects, buying land in Guangdong, Huizhou and Hainan’s ClearwaterBay for resort communities with hotels, homes and golf courses.

Agile said it reached an agreement with Aetos in November 2007 through its subsidiaries Huizhou Bailuhu and Ma Lee. Aetos paid Agile a 1.2 billion yuan deposit, and the parties agreed Agile would hold about 25 percent of the Huizhou Bailuhu development.

Caijing learned Aetos decided to terminate the agreement because Agile postponed a scheduled step in the project. Yet Agile claims Aetos cannot legally back out, and is now contesting the deposit claim.

Aetos’s spokesman said the company disagrees with Agile’s account of the dispute, but that no details would be released.

Public information shows Huizhou Bailuhu is a 5 billion yuan, 200 hectare, four-year project of Agile and the Huicheng government in Huizhou. Begun in 2007, the first phase – with villas, serviced apartment and five-star hotels – was priced at 1.8 billion yuan.

Aetos set up a US$ 2.2 billion hedge fund dedicated to Chinese real estate investments in 2007, later forming a partnership with China Life, China’s largest insurance company. Since then, Aetos has invested US$ 500 million in four Chinese projects including Huizhou Bailuhu.

Since the 2008 financial crisis, trouble has been brewing for hedge funds with real estate interests.

A foreign property investor told Caijing that it was a bad idea for “hedge funds with short cycles to invest in real estate with long development cycles.

“But in a bull market, there is a lot of room for hedge funds to maneuver due to a huge demand for hot money,” the investor said. “Things are totally different now. Hedge funds are in a quandary, facing angry clients and trapped investment.

“Projects in which hedge funds invested face stronger pressure than those with property fund investors.”

Aetos decided to bow out because the project faces rising risks in a slumping market, a source close to the deal told Caijing. The agreement said the foreign investor could quit, the source added, although it’s unclear whether the dispute will be resolved.

Agile said it has sufficient cash and financial resources, and would not be affected by the Huizhou Bailuhu debate. The 1.2 billion yuan deposit was listed on Agile’s books under “trade and other payables,” the developer added.

The credit rating agency Moody’s said the dispute would not affect Agile’s rating. “While a potential refund will weaken Agile’s liquidity, the company’s estimated cash holding of around 4.36 billion yuan as of December 2008 -- including restricted cash of about 1.36 billion yuan set aside for the Huizhou project -- and continued access to bank funds should partly temper the impact,” Moody’s said.

However, the dispute may delay the project’s progress. In addition, unlike the hopeful report from Moody’s, a Citibank analysis said the dispute would have a negative impact on Agile’s shares. Moreover, Aetos’ unilateral move indicates cooperation between Chinese property developers and hedge funds has reached a fragile stage.

Clouds Over Clearwater

Huizhou Bailuhu is by no means Agile’s only challenge. Another is the 20 billion yuan Clearwater Bay project, in which the developer shares interest with the U.S. investment bank Morgan Stanley.

Morgan Stanley’s property fund Crystal I bought a 30 percent stake in Clearwater Bay for 5.2 billion yuan in July. Caijing learned the project calls for a phased-in development over 10 years -- far exceeding the four- or five-year cycle typical among Morgan Stanley’s funds.

Apparently, Agile found it impossible to leverage a major tourism development project worth billions of yuan. As a result, the company was forced to hand over a project stake in exchange for private equity support.

But private funds are impatient. Rather than waiting for a project to be completed, fund managers usually require preferred dividends paid with pre-completion sales profits, squeezing developers who needs cash from sales to clients who buy before a project is finished. Some developers may have to promise high returns and accept tough terms.

And the developer’s U.S. investment partner may withdraw if it fails to get the expected returns. That could be fatal blow to Agile’s project on Hainan.

Neo-China’s Crisis

But Agile’s problems are like an everyday illness compared with the heart attacks jolting other big property developers.

Neo-China is among those on life support. Moody’s cut its rating for Hong Kong-listed Neo-China to Ca from Caa1 after the firm missed a January 23 deadline for an estimated 150 million yuan coupon payment on US$ 400 million in outstanding bonds. This rating -- Moody’s second-lowest -- is assigned to companies considered at or near default.

Neo-China has denied Moody’s claim of an overdue coupon payment. CEO Liu Yi said the payment was delayed for China’s Spring Festival, and that Neo-China has a 30-day grace period. Furthermore, the company has more than HK$ 2 billion in cash – plenty to cover what’s owed.

But as far as Moody’s knows, Neo-China is the first listed, mainland private developer facing a contract breach for failing to make an overseas coupon payment, said Kaven Tsang, an analyst for the ratings agency.

Caijing learned Neo-China aggressively acquired land in 2007, increasing its land reserve by 90 percent in a year to 14.8 million square meters as of last October. Holdings include the Zhuhai Qi’ao Island project, which is worth about 3.1 billion yuan.

This rapid expansion brought with it high-interest liabilities now at the root of Neo-China’s problems.

Hopson issued a US$ 200 million zero-coupon convertible bond overseas and a 1.83 billion yuan convertible bond in January 2007. Both are due in 2010.

Moody’s recently downgraded Greentown China’s corporate family rating to B1 from Ba3, and its senior unsecured bond rating to B2 from B1. Each rating carries a negative outlook.

Country Garden Holdings is one of several major developers that are saddled with convertible bonds or high-interest debt, some with 40 percent interest rates. Obviously, any overdue debt would lead to a developer’s sudden death.

Deadly VAM

The worst nightmare among Chinese developers, however, has been the gambling mechanism called VAM.

One such gambler was Changsheng China Property, which signed a VAM agreement in 2006 based on its plan for a HK$ 900 million initial public offering in Hong Kong scheduled for late 2008. The investor was a Goldman Sachs subsidiary, Sachs Strategic Investments (Asia) LLC, and the target property was China Plaza, a retail-commercial complex in Guangzhou.

Changsheng undersold China Plaza to pay off company debt in late 2008, after being forced to postpone the IPO. To meet the VAM agreement, Changsheng issued bonds in private placements to companies that were to be repaid unless an IPO succeeded by December 18. Since the listing flopped, Changsheng will have to sell projects to pay off bonds.

Agile, Neo-China and Changsheng are just a few of the firms rolling toward restructuring to avoid collapse. They’re trying to make ends meet, but often find themselves at the mercy of investors.

“Debt restructuring may be the ultimate result” for trapped developers, said one source. “No one wants to see a bankruptcy.”

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